Author Topic: What Weighting is the best Weighting for indexes?  (Read 3853 times)

nawhite

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What Weighting is the best Weighting for indexes?
« on: August 24, 2015, 08:46:46 AM »
Let's pretend you have $500,000. You get 500 free trades with an online broker. You're going to put your money somewhere and leave it for 25 years at least. Would you rather have:

1) $1000 of each stock in the S&P500
2) Exactly X shares of each stock in the S&P500, so say X is 10, 10 shares of Apple, 10 shares of Microsoft, 10 shares of Exxon etc. (I haven't done the math to figure out what X should be, but assume you figured out what that number was to get you really close to $500k total)
3) $500k of shares weighted by market cap ($19k in apple, $13.8K in Exxon, $9.2k in Microsoft, etc)
4) $500k of the Vanguard S&P500 index fund.

Personally, I know I'd rather have 3 instead of 4 because the Vanguard fund does the exact same thing but charges you an annual fee of $250 and their weighting penalizes companies where the founders retained lots of equity. http://www.joshuakennon.com/sp-500s-dirty-little-secret/ I like companies where the founders retained equity.

I'm not crazy about owning so much Apple stock so I think I like 1 and 2 over 3 but I don't know why one would be better than another, anyone want to chime in?

milesdividendmd

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Re: What Weighting is the best Weighting for indexes?
« Reply #1 on: August 24, 2015, 09:10:33 AM »
Only 3 and 4 don't require rebalancing to maintain your portfolio composition so they will be the cheapest to maintain.

And 3 is impossible unless you can buy fractional shares.

So probably 4.

Financial.Velociraptor

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Re: What Weighting is the best Weighting for indexes?
« Reply #2 on: August 24, 2015, 11:43:49 AM »
Joel Greenblatt (Hedge fund hero and Ivy League Finance Prof) has some recent research and a book on that topic: http://valueweightedindex.com/

CorpRaider

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Re: What Weighting is the best Weighting for indexes?
« Reply #3 on: August 24, 2015, 11:55:18 AM »
1, then 3, then 4.  Even the fama/bogleheads would admit to historical outperformance of the EW index.  They would just attribute it to SMB tilt.  The reason Vanguard uses 4 rather than three is obviated when you're not talking about billions of dollars to invest.

neil

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Re: What Weighting is the best Weighting for indexes?
« Reply #4 on: August 24, 2015, 02:36:02 PM »
I think everyone loves #3 in theory but in practice you have to deal with M&A, index composition, dividends, etc.  Even if trading was entirely free, I would not want to do it.  And no matter how "long term" a real investor is, it's rare to literally not touch your account unless you forget about it or died. 

seattlecyclone

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Re: What Weighting is the best Weighting for indexes?
« Reply #5 on: August 24, 2015, 02:49:18 PM »
Anything but #2. The price of one share of a given company is entirely arbitrary, and is not a reasonable basis for an investment strategy.

nawhite

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Re: What Weighting is the best Weighting for indexes?
« Reply #6 on: August 25, 2015, 07:56:46 AM »
1, then 3, then 4.  Even the fama/bogleheads would admit to historical outperformance of the EW index.  They would just attribute it to SMB tilt.  The reason Vanguard uses 4 rather than three is obviated when you're not talking about billions of dollars to invest.

I agree with you, I'm not sure why I should weight Apple higher in my holdings b/c I don't think it will perform better than a smaller company. It absolutely makes sense that Vanguard can't do it because there isn't enough liquidity in the smaller companies but why don't more people here do it? It seems to be a minority opinion in this thread so far. Making your own personal index with an equal weighting decreases your fees (assuming you don't try to continually track the 500 companies in the index and just keep your 500 companies), increases your long term returns (with a slight increase in volatility), and makes tax loss/gain harvesting easier if you're into that sort of thing. Seems like a win-win-win to me.

seattlecyclone

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Re: What Weighting is the best Weighting for indexes?
« Reply #7 on: August 25, 2015, 09:37:48 AM »
Making my own personal equal-weighted index would require me to go ahead and put in orders for 500 different stocks. Then as the stocks rise and fall relative to each other, I would need to be monitoring each of them, buying and selling shares to ensure that my holdings of each remain roughly equal. Even if I could make that many stock trades for free, I have no interest in spending that much time maintaining my portfolio.

As to why Vanguard doesn't do it, I think the issue is less about liquidity and more about the trading churn. The trading you need to do to maintain equal weightings adds a ton to the expense ratio and also would require them to distribute large amounts of capital gains to their shareholders. Market cap weighting, by contrast, requires very few trades. You just buy x% of each company's shares, and the weighting maintains itself so long as the number of shares remains constant. The number of shares doesn't remain constant in real life, of course, but this number fluctuates much less than relative per-share prices of different companies.

nawhite

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Re: What Weighting is the best Weighting for indexes?
« Reply #8 on: August 25, 2015, 10:09:50 AM »
Making my own personal equal-weighted index would require me to go ahead and put in orders for 500 different stocks. Then as the stocks rise and fall relative to each other, I would need to be monitoring each of them, buying and selling shares to ensure that my holdings of each remain roughly equal. Even if I could make that many stock trades for free, I have no interest in spending that much time maintaining my portfolio.

As to why Vanguard doesn't do it, I think the issue is less about liquidity and more about the trading churn. The trading you need to do to maintain equal weightings adds a ton to the expense ratio and also would require them to distribute large amounts of capital gains to their shareholders. Market cap weighting, by contrast, requires very few trades. You just buy x% of each company's shares, and the weighting maintains itself so long as the number of shares remains constant. The number of shares doesn't remain constant in real life, of course, but this number fluctuates much less than relative per-share prices of different companies.

So why is that inherently better than just rebalancing once per year or once per quarter when you get your dividends, using that money to rebalance things? I'm sure if I had an account with $500k in it I could get a decent number of free trades to do the rebalancing.

seattlecyclone

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Re: What Weighting is the best Weighting for indexes?
« Reply #9 on: August 25, 2015, 11:34:24 AM »
I personally just don't want to mess with it. Maintaining a tax-optimized asset allocation with mutual funds alone is complicated enough, given that my wife and I each have a 401(k) account and HSA account with completely different investment options from our Vanguard IRAs and joint taxable account. We're only invested in about a dozen different funds and it's already a headache. I have no patience for rebalancing 500 different stocks on a quarterly basis, even before you consider the fact that the transaction fees and capital gains taxes would likely eat away much (if not all) of the benefit of equal weighting.

milesdividendmd

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Re: What Weighting is the best Weighting for indexes?
« Reply #10 on: August 25, 2015, 12:44:06 PM »

Making my own personal equal-weighted index would require me to go ahead and put in orders for 500 different stocks. Then as the stocks rise and fall relative to each other, I would need to be monitoring each of them, buying and selling shares to ensure that my holdings of each remain roughly equal. Even if I could make that many stock trades for free, I have no interest in spending that much time maintaining my portfolio.

As to why Vanguard doesn't do it, I think the issue is less about liquidity and more about the trading churn. The trading you need to do to maintain equal weightings adds a ton to the expense ratio and also would require them to distribute large amounts of capital gains to their shareholders. Market cap weighting, by contrast, requires very few trades. You just buy x% of each company's shares, and the weighting maintains itself so long as the number of shares remains constant. The number of shares doesn't remain constant in real life, of course, but this number fluctuates much less than relative per-share prices of different companies.

So why is that inherently better than just rebalancing once per year or once per quarter when you get your dividends, using that money to rebalance things? I'm sure if I had an account with $500k in it I could get a decent number of free trades to do the rebalancing.

Because cap weighted indices rebalance themselves. Equal weighting requires trading to maintain equal weight.

This is why non cap weighted indices are always more expensive.

The only outperformance you get from equal weighting (or any fundamental weighting)  is from exposure to the size and value factors.

So you are just as well (and are maybe more cost effective) by mixing some small/value fund into your portfolio.

Nothing magical about equal weighting at all. Definitely not s free lunch.